375 F.3d 168 (2nd Cir. 2004), 03-7652, Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co. of New York

Docket Nº:03-7652.
Citation:375 F.3d 168
Party Name:ETERNITY GLOBAL MASTER FUND LIMITED, Plaintiff-Appellant, v. MORGAN GUARANTY TRUST COMPANY OF NEW YORK and JPMorgan Chase Bank, Defendants-Appellees,
Case Date:July 09, 2004
Court:United States Courts of Appeals, Court of Appeals for the Second Circuit

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375 F.3d 168 (2nd Cir. 2004)



MORGAN GUARANTY TRUST COMPANY OF NEW YORK and JPMorgan Chase Bank, Defendants-Appellees,

No. 03-7652.

United States Court of Appeals, Second Circuit

July 9, 2004

Argued: Feb. 12, 2004.

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[Copyrighted Material Omitted]

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James S. Renard (William A. Brewer III, Daniel L. Brown, and Steven M. Reiness on the brief) Bickel & Brewer, New York, N.Y. for Appellant.

Nancy E. Schwarzkopf, J.P. Morgan Chase Legal Department, New York, N.Y. (Charles A. Gall, James W. Bowen, Jenkens & Gilchrist, Dallas, TX on the brief) for Appellees.

Before: JACOBS, SACK and RAGGI, Circuit Judges.

JACOBS, Circuit Judge.

Plaintiff-Appellant Eternity Global Master Fund Limited ("Eternity" or "the Fund") purchased credit default swaps ("CDSs" or "the CDS contracts") from Defendants-Appellees Morgan Guaranty Trust Company of New York and JPMorgan Chase Bank (collectively, "Morgan") in October 2001. Eternity appeals from a final judgment entered in the United States District Court for the Southern District of New York (McKenna, J.), dismissing with prejudice its complaint alleging breach of contract, fraud, and negligent misrepresentation by Morgan in connection with the CDSs. The CDS contracts were written on the sovereign bonds of Argentina and would be "triggered" upon the occurrence of a "credit event," such that if Argentina restructured or defaulted on that debt, Eternity would have the right to put to Morgan a stipulated amount of the bonds for purchase at par value.

In late November 2001, the government of the Republic of Argentina, in the grip of economic crisis, initiated a "voluntary debt exchange" in which bondholders had the option of turning in their bonds for secured loans on terms less favorable except that the loans were secured by certain Argentine federal tax revenues. Eternity informed Morgan that the voluntary debt exchange was a credit event that triggered

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Morgan's obligations under the CDS contracts. Morgan disagreed.

In February 2002, Eternity filed suit alleging breach of contract and fraudulent and negligent misrepresentation. Morgan moved to dismiss for failure to state a claim pursuant to Federal Rule of Civil Procedure ("Rule") 12(b)(6). In an unreported decision, the district court preserved Eternity's contract claim but dismissed the misrepresentation claims for want of the particularity required by Rule 9(b). Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., No. 02 Civ. 1312, 2002 WL 31426310, at *5-7 (S.D.N.Y. Oct. 29, 2002) ("Eternity I "). Eternity amended its complaint in an effort to redress the deficiencies noted by the district court; and Morgan again moved to dismiss. The district court again held that Eternity's misrepresentation claims were insufficiently pled and went on to reconsider its ruling on the breach of contract claim. Upon reconsideration, the court held that the claim failed as a matter of law. Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., No. 02 Civ. 1312, 2003 WL 21305355, at *2-6 (S.D.N.Y. June 5, 2003) ("Eternity II ").

On appeal, Eternity challenges the dismissal of its claims. For the reasons set forth below, we affirm the dismissal of the fraudulent and negligent misrepresentation claims but reverse the dismissal of the contract claim and remand for further proceedings.


On behalf of its investors, Eternity trades in global bonds, equities and currencies, including emerging-market debt. During the relevant period, Eternity's investment portfolio included short-term Argentine sovereign and corporate bonds. In emerging markets such as Argentina, a significant credit risk is "country risk," i.e., "the risk that economic, social, and political conditions and events in a foreign country will adversely affect an institution's financial interests," including "the possibility of nationalization or expropriation of assets, government repudiation of external indebtedness, ... and currency depreciation or devaluation." 1 Credit risk can be managed, however. 2 Banks, investment funds and other institutions increasingly use financial contracts known as "credit derivatives" to mitigate credit risk. 3 In October 2001, in light of Argentina's rapidly deteriorating political and economic prospects, Eternity purchased CDSs to hedge the credit risk on its in-country investments.


By way of introduction, we briefly review the terminology, documentation, and structure of Eternity's credit default swaps.

A. Terminology

A credit default swap is the most common form of credit derivative, i.e., "[a]

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contract which transfers credit risk from a protection buyer to a credit protection seller." 4 Protection buyers (here, Eternity) can use credit derivatives to manage particular market exposures and return-on-investment 5; and protection sellers (here, Morgan) generally use credit derivatives to earn income and diversify their own investment portfolios. 6 Simply put, a credit default swap is a bilateral financial contract in which "[a] protection buyer makes[ ] periodic payments to ... the protection seller, in return for a contingent payment if a predefined credit event occurs in the reference credit," i.e., the obligation on which the contract is written. 7

Often, the reference asset that the protection buyer delivers to the protection seller following a credit event is the instrument that is being hedged. 8 But in emerging markets, an investor may calculate that a particular credit risk "is reasonably correlated with the performance of [the sovereign] itself," 9 so that (as here) the investor may seek to isolate and hedge country risk with credit default swaps written on some portion of the sovereign's outstanding debt. 10

In many contexts a "default" is a simple failure to pay; in a credit default swap, it references a stipulated bundle of "credit events" (such as bankruptcy, debt moratoria, 11 and debt restructurings) that will trigger the protection seller's obligation to "settle" the contract via the swap mechanism agreed to between the parties. 12 The entire bundle is typically made subject to a materiality threshold. 13 The occurrence of a credit event triggers the "swap," i.e., the protection seller's obligation to pay on the contract according to the settlement mechanism. "The contingent payment can be

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based on cash settlement ... or physical delivery of the reference asset, in exchange for a cash payment equal to the initial notional [i.e., face] amount [of the CDS contract]." 14 A CDS buyer holding a sufficient amount of the reference credit can simply tender it to the CDS seller for payment; but ownership of the reference credit prior to default is unnecessary. If a credit event occurs with respect to the obligation(s) named in a CDS, and notice thereof has been given 15 (and the CDS buyer has otherwise performed), the CDS seller must settle. Liquidity in a secondary market increases the usefulness of a CDS as a hedging tool, though the limited depth of that market "can make it difficult to offset ... positions prior to contract maturity." 16

B. Documentation

The principal issue dividing the parties is whether the CDS contracts at issue are ambiguous in any material respect. "An ambiguity exists where the terms of a contract could suggest 'more than one meaning when viewed objectively by a reasonably intelligent person who has examined the context of the entire integrated agreement and who is cognizant of the customs, practices, usages and terminology as generally understood in the particular trade or business.' " Alexander & Alexander Servs., Inc. v. These Certain Underwriters at Lloyd's, London, 136 F.3d 82, 86 (2d Cir.1998) (quoting Lightfoot v. Union Carbide Corp., 110 F.3d 898, 906 (2d Cir.1997)).

In this case, we assess ambiguity in the disputed CDS contracts by looking to (i) the terms of the three credit default swaps; (ii) the terms of the International Swaps and Derivatives Association's ("ISDA" or "the Association") "Master Swap Agreement," on which those swaps are predicated, (iii) ISDA's 1999 Credit Derivatives Definitions--which are incorporated into the disputed contracts; and (iv) the background "customs, practices, [and] usages" of the credit derivatives trade, id. Because customs and usages matter, and because documentation promulgated by the ISDA was used by the parties to this dispute, we briefly review some relevant background.

The term "derivatives" references "a vast array of privately negotiated over-the counter ... and exchange traded transactions," including interest-rate swaps, currency swaps, commodity price swaps and credit derivatives--which include credit default swaps. 17 A derivative is a bilateral contract that is typically negotiated by phone and followed by an exchange of confirmatory faxes that constitute the contract but do not specify such terms as events of default, representations and warranties, covenants, liquidated damages, and choice of law. 18 These (and other) terms are typically found in a "Master Swap Agreement," which, prior to standardization efforts that began in the mid-1980s, "took the form of separate 15-to 25-

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page agreements for each transaction." 19

Documentation of derivatives transactions has become streamlined, chiefly through industry adherence to "Master Agreements" promulgated by the ISDA. In 1999, Eternity and Morgan entered the ISDA Multicurrency-Cross Border Master Agreement, which governs, inter alia, the CDS transactions disputed on appeal. Each disputed CDS also incorporates the 1999 ISDA Credit Derivatives Definitions, the Association's first attempt at a comprehensive lexicon governing credit derivatives transactions. 20 Last year, due to the rapid evolution of "ISDA documentation for credit default swaps," the Association began market implementation of the 2003 Credit...

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